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When engaging in trading activities it is important to understand the hierarchy behind the commission you pay. Whether you are buying stocks, bonds, options, or some other derivative, there are a series of players and each one of them needs to get paid. Although in some cases additional fees are charged by the investment you're making on an ongoing basis, most stocks do not charge ongoing fees.

Therefore, the primary hierarchy is rooted at the market maker level. Market makers are the ones who execute trades for the brokerage firms or clearinghouses, matching orders to buy or sell the same security to facilitate the transactions efficiently. Market makers include firms like Island, Arca, NYSE, etc., and they make the transactions possible.

Typically, when market makers execute a transaction they realize a small margin in profit per share. For example, if they transacted an order to buy shares of stock at $85.50 they may actually have bought it at $85.49, making one penny in profit per share. When market makers execute orders for hundreds of millions of shares, one penny goes a long way.

The next level in this hierarchy is often a brokerage firm directly, although sometimes clearinghouses also play a role. However, in many cases, brokerage firms are their own clearinghouses so we will focus on that condition.

Every brokerage firm charges commission, which is one way they make money, but some brokerage firms do more than just charge a commission. Some brokerage firms make money on order flow as well. Order flow could mean one of two things, or both, but it is important to recognize that although all firms charge commission for the transactions they execute, not all commissions are the same; in many cases the difference in execution quality changes the cost of the transaction completely.

Order flow revenue can come in the form of rebates from the market maker directly when liquidity is added to the market for that particular security by the brokerage firm placing the order. In other words, if the brokerage firm placing the order allows the market maker to execute the trade at a price that is less than ideal for the client the brokerage firm who executes the trade is rewarded by the market maker in the form of order flow revenue, which is called a rebate. In this case, the brokerage firm makes more than he otherwise would because he passed the order to a market maker who in turn 'worked the order' for an additional spread.

In the example above the spread was one penny, and the typical participation rate is 50% when a brokerage firm passes an order to a market maker who provides a rebate, so that equates to 1/2 penny for the brokerage firm executing the transaction. Assume you buy 10,000 shares worth of stock and your brokerage firm tells you that your commission charge will be $9.99. If the brokerage firm is also making 1/2 penny, your real commission charge is almost $60.00.

That example is traditional order flow revenue, but some brokerage firms take it even further. Some brokerage firms look to increase their revenue by working the order at the brokerage level as well. Therefore, they look to realize revenue from order flow not only from the market maker, but also in house. Using our one penny example, if the brokerage firm worked an order for one penny in house and also passed it to a market maker who provided a rebate the brokerage firm would be collecting $150 in addition to the commission they charged for the transaction.

Most investors don't recognize this or have come to accept it as part of the business, but for people interested in making money by trading stocks losing $60 or $150 of potential profit every time you make a trade is absolutely important. In addition, traders that are looking for fast execution, when your order is being worked by the brokerage firm or market maker, substantial time delays exist between the time you place the trade and the time the trade actually executes if they work your order (not acceptable).

Firms that typically make money from order flow include TD Ameritrade Holding Corp. (NYSE:AMTD), E TRADE Financial Corporation (NASDAQ:ETFC), Charles Schwab Corp (NYSE:SCHW), and Fidelity. In some cases order flow makes up the margin that allows these companies to be profitable.

Not unlike what we see in the airline industry where airlines need to charge extra fees for baggage and accept commercial cargo in order to turn a profit, many of the discount brokers would not make any money were it not from the order flow rebates that they receive from market makers and exchanges.

Scrutiny has recently been paid to this practice, and there is a good chance evidence exists suggesting that many of the firms who are paid for order flow are not actually attempting to achieve best execution for their clients even though they claim to be doing so. This is a major concern, it raises legal and regulatory questions, but on a client level it should tell you something.

Consumers make their decisions with their pocketbooks and investors should do the same thing. When your eyes are open enough to recognize that the brokerage firm that you are working with is actually charging you much more in commission than they claim your decision as an investor should be to look elsewhere, and find a brokerage firm who either does not engage in this practice or who willfully passes on that rebate to you as the investor.

Yes, there are some firms who will pass on those rebates to you, whose business is not dependent on order flow, but quite often the face value of the commissions charged by those brokerage firms is higher than the commissions charged by firms that rely on order flow revenue. Those higher face value commissions in most cases are actually substantially lower than what the real commission charges ultimately are.

From a best practice standpoint, many of the firms on Wall Street today are not seeking best execution for their clients, that should concern regulators, but more importantly that also should concern every individual investor. Investigate, do your homework, and identify exactly how much you're paying in commission and in most cases you'll be surprised. The $4.99 or $9.99 face value is actually far less than you actually are paying.